Exam 11: Cash Flow Estimation and Risk Analysis

You work for the Sing Oil Company, which is considering a new project whose data are shown below. What is the project's net operating cash flow for Year 1?

An increase in the risk-adjusted discount rate for a risky project will result in which of the following?

Zeta Software is considering a new project whose data are shown below. The required equipment has a 3-year project life, after which it will be worthless, and it has a constant deduction rate over 3 years. Revenues and cash operating costs are expected to be constant over the project's 3-year life. What is the project's operating cash flow for Year 1?

Using the same discount rate to evaluate projects with differing degrees of risk would, over time, cause the firm to accept too many high-risk projects and to reject too many low-risk proposals.

If a firm's projects differ in risk, then different projects should be evaluated using risk-adjusted discount rates.

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not relevant in a capital budgeting analysis.

After a project has been terminated, a firm cannot receive CCA deductions from it, and thus the CCA tax shield stops too.

California Hideaways is considering a new project whose data are shown below. The equipment has a 4-year project life. This equipment falls into class 43 with a CCA rate of 30% and would have zero salvage value. No new working capital would be required. Revenues and cash operating costs are expected to be constant over the project's 4-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 4.)

Bing Services is now in the final year of a project. The equipment originally cost $20,000. The existing UCC is $5,000. Bing can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipment's net after-tax salvage value for use in a capital budgeting analysis? Note that the recapture is fully taxable.

Which of the following statements is correct?

Which of the following rules is correct for capital budgeting analysis?

Any cash flow that can be classified as incremental to a particular project is relevant in a capital budgeting analysis.

TexMex Products is considering a new salsa whose data are shown below. The equipment has a constant capital cost allowance over its 3-year life with a zero salvage value. No new working capital would be required. Revenues and cash operating costs are expected to be constant over the project's 3- year life. However, this project would compete with other TexMex products and would reduce the company's pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3. Actual CCA varies. The proposed CCA is for computational convenience.)

Easy Payment Loan Company is thinking of opening a new office, and the key data are shown below. Easy Payment owns the building, free and clear, and it would sell it for $100,000 after taxes if the company decides not to open the new office. The equipment that would be used would be depreciated by the straight-line method over the project's 3-year life, and would have a zero salvage value. An extra $5,000 of new working capital would be required to get this project running. Revenues and cash operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3 and the increased working capital will be recovered when this project ends. A simplified CCA is for mathematical convenience.)

Sometimes analysts think that an externality is present in a project, but they recognize that the particular externality cannot be quantified with any precision-estimates of its effect would really just be guesses. In such a situation, the externality should be ignored, i.e., not considered at all, because if it were considered it would make the analysis appear more precise than it actually is.

Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, the project's initial outlays and subsequent costs for large projects can be forecasted with great accuracy.

Which of the following does NOT have incremental cash flow effects and thus should NOT be considered in capital budgeting decisions?

Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than one of the company's average projects. Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is correct?

Merritt Company is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. Merritt could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, Merritt would have to make a payment to those parties. How much is the option to abandon worth (in thousands) to Merritt? WACC = 11)5% Dollars in Thousands NPV this Prob × T = 0 t = 1 t = 2 t = 3 State NPV Prob = 25% $800.0 $800.0 $800.0 $938.1 $234.5 Prob = 50% -$1,000 $520.0 $520.0 $520.0 $259.8 $129.9 Prob = 25% -$200.0 -$200.0 -$200.0 -$1,484.5 -$371.1 Exp) NPV= -$6.7

Changes in net operating working capital do not need to be considered in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital.